The Macro Economy

Economic Objectives

• Low Unemployment• High but sustainable economic growth• Low and stable inflation (target is 2%)• Balanced balance of payments

Government Objectives

The role of the government is to provide a stable environment in which business can flourish. It aims to provide the highest possible trend rate of growth.

Government and the cycle – too high growth rates are rarely sustainable. Current governments have taken to trying to dampen down the extremes of the cycle so that recessions are not as deep or recoveries as sharp as they have been in the past.

AD / AS Analysis

• This gives us a model of how the economy works and how output and employment is determined.

• Demand may not be at an optimum level. Governments may use monetary and fiscal policy to influence the level of AD

• Long run growth is determined by AS

A combination of policies can be used to achieve objectives

• DEMAND SIDE POLICIES – about changing the level of aggregate demand (spending)

• Monetary Policy – the use of interest rates and control of the money supply to achieve macroeconomic objectives

• Fiscal Policy – the use taxation and government spending to achieve macroeconomic objectives

• SUPPLY SIDE POLICIES – about increasing the economies capacity to produce goods and services

Tackling Unemployment

• Increase aggregate demand in the economy. More demand = more spending = more output = more employment (lower unemployment)

• Expansionary fiscal and monetary policy• Supply Side Policies• Eg education and training to help peopl gain

employment

Economy Overheating – Inflation above target

• Contractionary Monetary Policy – increase interest rates – more incentive to save – people pay more back on mortgages – demand in the economy falls – inflationary pressures reduced

• Contractionary Fiscal Policy (budget surplus?)– tax up – gov spending down – lower aggregate demand – inflationary pressures reduced

• Supply Side Policies – allow demand to grow without increasing prices by increasing economies productive potential

Economy in Recession or Slowdown – growth low or negative

• Expansionary Monetary Policy• Expansionary Fiscal Policy• Supply Side Policies

• HOWEVER – evaluate!!!!• Eg expansionary monetary policy to increase

growth may lead to inflation rising above target

Macro Economic Policy

Fiscal Policy• Is the use of government spending and

taxation to achieve economic objectives

Fiscal Policy

• Expansionary (Reflationary) Fiscal Policy – if the economy is in a slowdown, or recession, the government may cut taxes and increase government spending, in order to increase aggregate demand (spending) in the economy.

• Contractionary (Deflationary) Fiscal Policy – If the economy is overheating, with too much inflation, the government may increase taxes and reduce government spending, in order to reduce aggregate demand (spending) in the economy.

You need to be able to explain.• Example• A cut in direct taxation such as income tax.• Will increase people’s disposable income.• As a result there will be more aggregate demand and spending in

the economy• Therefore businesses will produce more in response to higher

demand• As a result GDP will be higher (economic growth)• More people will be needed to produce higher output (lower

unemployment)• However there may be an upward pressure on prices (demand

pull inflation)

Fiscal Policy – Key Concepts

• Budget Deficit – is where the government spends more than it takes in revenue from taxation and other sources. An expansionary fiscal policy may involve deliberately running a budget deficit so as to increase total demand in the economy. This may be done if the economy is growing slowly or in a recession

• Budget Surplus – is where the government spends less than it takes in revenue from taxation and other sources. A contractionary fiscal policy may involve deliberately running a budget surplus so as to reduce total demand in the economy. This may be done if the economy is overheating and inflation is rising

Tax and Spend – Key Terms• Tax – a compulsory payment to the government• Direct Tax – a tax on income and wealth paid directly to the government• Indirect Tax – a tax on spending. Often defined as a tax on goods and services.

We pay this indirectly through the price of something• Progressive Tax – Takes a greater proportion of income from higher incomes• Regressive Tax – Takes a greater proportion of incomes from lower incomes• Proportional Tax – Takes the same proportion of income from all income levels

Government Spending & Business The impact will depend upon what the government spends its money

on

• Increases in spending may create more demand in the economy

• Spending may be targeted in order to support certain areas – eg car scrappage scheme

• Spending on roads, buildings etc may support construction industry

• The multiplier effect – this is where an injection of spending creates more spending than the initial amount spent. (can be regional or national)

The Multiplier Effect

• Where an injection of spending in the economy leads to more spending than the initial amount spend. Eg

• Government builds school – incomes of builders etc rises – these people are able to spend more – increased spending represents income for other business – these businesses may increase output and employ more people as their income rises – a lot of this extra income will be spent generating more income for other businesses etc

Economic Effects of Changes in Direct Taxation

• Direct Taxes such as income tax help to reduce inequalities in income as they are progressive

• High Direct Taxes may harm incentives. Income tax may deter workers from working longer, seeking promotion or moving to higher paid jobs.

• Unemployment Trap – taxes such as income tax may even deter people from working at all if their income after tax is not much higher than income from benefits when not working

• High Direct Taxes may discourage entrepreneurship and even lead to business locating in another country

Economic Effects of Changes in Indirect Taxation

• Choice – Taxpayers have a choice as they only pay the tax if they purchase the commodity on which the tax is raised

• Indirect Taxes affect the pattern of demand – consumers will reduce the consumption of goods and services with the highest taxes on them. This can lead to less output and employment in those industries

• Indirect taxes tend to be regressive – poorer people pay a higher proportion of their income in tax

• Indirect taxes – can be used to discourage the consumption of demerit goods or goods with high external costs such as cigarettes, alcohol and petrol

Tax!

• The impact of any tax cut on spending will depend upon the Marginal Propensity to Consume (MPC). This is the proportion of any extra income that will be spent. Mine is likely to be lower than yours!

• The government is currently spending more than it takes in taxation – it is borrowing and it can’t do this for ever

• Robin Hood Economics – Tax from rich and give to the poor is likely to create the most spending in the short term.

Evaluating the Effects of Fiscal Policy

• Imprecise Tool - Affects demand and spending BUT – difficult to judge and estimate the impact any decision might have (eg size of multipliers)

• Side Effects of Policy – Expansionary may add to inflationary pressures. Contractionary may lead to slower growth and rising unemployment

• May Conflict with Other Objectives – eg government would be reluctant to undertake an expansionary fiscal policy at present as it is trying to cut the budget deficit

The Importance of the Budget Deficit

• In recent years the UK government has faced a difficult trade off in its objectives for demand management:

• On the one hand – the economy has been operating at well below full capacity as a result of the recent recession. This would suggest a need for an expansionary fiscal policy to boost aggregate demand in the economy

• On the other hand – we have a large budget deficit and national debt as a percentage of GDP has risen to levels not seen since the end of WW2. this would suggest a need for a contractionary fiscal policy

• Why does the deficit matter?• A high proportion of government revenue is being used to pay the interest

on the national debt• The debt imposes a burden on future generations• If we do not tackle the deficit it could affect the UK’s credit rating. If our

credit rating falls we may have to pay higher interest on the debt.

Monetary PolicyThe use of interest rates and the supply of money to achieve Macro Economic objectives. The Bank of England is responsible for monetary policy in the UK and is tasked with keeping inflation at 2% (+ or – 1%)

Interest Rate Policy

• Expansionary Monetary Policy – if the economy is in a slowdown, or recession, and inflation is below target the Bank of England may cut interest rates in order to increase total demand and spending in the economy.

• Contractionary Monetary Policy – If the economy is overheating, with too much inflation, the Bank of England may increase interest rates in order to reduce total demand and spending in the economy.

How does interest rate policy work?

• A rise in interest rates• Makes saving more rewarding so consumers

may spend less• Makes borrowing more expensive so

consumers may spend less on credit• Makes borrowing more expensive for firms so

investment expenditure falls• Means many people have higher mortgage

repayments so their disposable income falls and they have less to spend

Evaluating the Effects of Monetary Policy

• Time Lags – The MPC meets monthly so it can react quickly to changes in the economy. It is also quicker to react than fiscal policy BUT – it still takes time for the full impact of interest changes to affect the economy

• Exchange Rate Effects – Changes in interest rates can also affect the exchange rate and so can impact upon the Balance of Payments

• Policy Conflicts – higher interest rates now to combat inflation could send us back into recession

Supply Side Policies• Policies that increase the ability

of the economy to supply more goods and services

• If successful, this means that when demand rises in the economy, this will lead to a greater GDP (economic growth) without inflation being a problem

Supply Side Policies Examples• Education and Training - make workforce more productive and flexible –

human capital• Reducing Direct Taxes – on lower income earners increases the incentive to

work – on higher income earners may increase incentive to work hard or work in the UK rather than somewhere else

• Reducing Benefits – Increases incentive to work• Encouraging Enterprise – through tax relief, grants and subsidies – new

business should lead to more output and more growth• Encouraging new technology and innovation – capital allowances to

encourage investment and R&D – Helps to increase productive capacity of the economy

• Reducing Monopoly Power – monopolies restrict output and increase prices. Reducing monopoly power helps increase total supply in the economy

• Reduce Union Power – as these act as monopolies in the labour market

Evaluating the Effects of Supply Side Policies

• Long Term – often take a long time to put into effect and to have an impact

• Controversial – may face resistance from some groups in the economy – eg trade unions will oppose policies to limit their powers. Reducing benefits may hurt vulnerable groups in society.

TradeoffsIt is difficult to achieve all objectives all of the time

Comparing Policies

PolicyDemand Side Supply Side

Fiscal

Monetary

Demand can be affected

fairly quickly by policy changes

Long Term

Eg – changes in education

may take years to be effective

Changes made annually in

budget

MPC meet monthly

Quite Flexible but….

Not Flexible enough to

react to changes in the economy in the

short term

Possible Questions• Assess the likely effects on UK Inflation of rising energy bills (10 marks)• Assess the likely effects of rising energy bills on the UK Economy (12 marks)• To what extent does Britain’s budget deficit make it difficult for the UK government to

follow the energy policy it would like (10 marks)• Assess the economic case for subsidising windfarms – evidence D (12 marks)• Assess the extent to which subsidising windfarms creates economic benefits (12

marks)• Assess the case for the UK government paying cold weather payments to vulnerable

people (10 marks)• Analyse two reasons why of those in debt on their energy bills, 41% owe more than

they did 12 months ago - evidence H (8 marks)• Assess the potential impact of rising levels of energy bill debt on the UK economy (12

marks)• Assess the potential impact of disruptions to Norwegian gas supplies for the UK

Economy (10 marks)• Assess the extent to which energy security is important to the UK economy (10 marks)